Market odds of a rate hike for the September meeting were just about 22 percent Wednesday, and close to 60 percent for December.
The Bank of Japan overnightsaid it would continue its 80 trillion yen of asset purchases, but it would focus on steepening the yield curve. The BOJ plans to remain active in the 10-year sector and focus on keeping the rate of the 10-year Japanese Government Bond at around zero. The 10-year JGB was yielding -0.027 percent Wednesday morning. It also did not cut yields further into negative territory, as expected by some.
"The Fed isn't one to be brave in this cycle," said Bank of the West chief economist Scott Anderson. He does not expect the Fed to raise rates for just the second time in 10 years with the market so off sides.
"I think they'd create a pretty big tank in the stock market. I think the Fed's going to want to telegraph this pretty strongly. They might put the market on notice that this should be penciled in," he said.
Stock futures were higher Wednesday morning, and the dollar was weaker after initially rising on the Bank of Japan news. The yen strengthened, and dollar/yen was at 100.
The Fed meanwhile, is expected to do no more than gently talk the market into its next rate hike. Ninety percent of the respondents in the latest CNBC Fed survey expect the central bank to stay on hold at this week's meeting. Most economists expect the Fed to hold off on a rate hike until December.
The CNBC survey also found that 31 percent believe the Fed will not hike because of global growth concerns, and 22 percent say it is because the markets are unprepared. But 25 percent see other reasons, which include softer and inconsistent U.S. data. Only 11 percent expect the election to keep the Fed sidelined.
According to the survey, 66 percent believe the Fed pays too much attention to market reactions and 58 percent said it focuses too much on high frequency data, like the monthly jobs report or latest inflation data.
Chris Rupkey, chief financial economist at MUFG Union Bank, said his recommendation is that the Fed hike now, even with softer August data. The August employment report showed just 151,000 jobs created, 30,000 fewer than expected, and retail sales were disappointing.
"I think people are hiding behind the fact that futures markets have 20 percent odds of a move, and the Fed would not go against that, but my reading is that's not relevant in this case because the market's never going to give them a green light. The longer the Fed goes on, the market is going to do what it does," said Rupkey.
Fed officials shook up the markets in late August when Yellen and two of her inner circle — Vice Chair Stanley Fischer and New York Fed President William Dudley — said a rate hike is possible in September. Two Fed governors, Daniel Tarullo and Lael Brainard, within days swayed markets the other way, saying the Fed could be patient about hiking rates. But since then much of the August data has come in softer than expected. ISM manufacturing activity actually contracted and ISM services growth is slowing dramatically.
While it's unclear whether the economy has just hit a temporary soft patch, economists still see better growth in the second half of the year.
For that reason, some believe the Fed could signal a "hawkish hold" while sounding more confident on the economy. Fed officials are also likely to alter their interest rate outlook. If there is no hike, the outlook for rates this year could fall to one rate hike, from the current two. Fed officials could also tweak forecasts for 2017 and 2018, which now have projections for four rate hikes each.
"I think the Fed has to get over its fear of what the markets are going to do. It should certainly get over any fear of unleashing a new taper tantrum," said Rupkey, referring to a market sell-off when the Fed stepped back from an easing program. "The market itself is not right now, and it probably needs a wake-up call by the Fed."
Anderson said he is watching the Fed's so-called dot plot, or rate forecast chart for changes, and also its inflation forecast. He expects Yellen's comments at the press conference to be perhaps even more important.
"She certainly signaled the case for a rate hike has strengthened. Let's see if she stays with that," he said. "Stocks will be in celebration mode if the Fed holds off. I do think valuations are stretched though, and we're in a hair-trigger environment. If we get some surprise from the Fed … that could throw the market into a tizzy."
But Anderson expects the Fed to emerge from the meeting building a case that it's closer to a rate hike, without specifics. "They've been burned so many times," he said. "They're going to be very cautious about burning their last remaining amount of credibility. They'll be humble in terms of their economic and rate forecasts, given they've been so wrong."